Who's Refinancing?

Those homeowners who bought their castle with a payment-option ARM (often touted by your local lender as the Option ARM) are among the most likely of refinancers, but relatively few of them have the wherewithal to manage what is probably a sizable step up in interest rate.

An Option ARM taken two years ago may have had a payment rate of perhaps 1% and an underlying interest rate of around 4%. Today, that payment rate has risen only slightly, while the actual rate the borrower is being charged has run as high as the mid-7% range. In plain English, many Option ARM borrowers are watching their loan balance rise, not fall -- a situation known as negative amortization -- and may be refinancing to avoid eroding all the equity in their property. However, with mortgage interest rates for all products hovering near 6%, these borrowers may have trouble finding a suitable loan. A new hybrid ARM with interest-only payments may be a product to stave off the equity drain, if nothing else.

Like homeowners who took a payment-option ARM, mortgage holders with older Hybrid ARMs approaching their first rate and payment adjustments are also potential refinancers. A borrower who selected a 3/1 Hybrid (fixed for three years) back in late 2003/early 2004 likely got an interest rate of right around 5% -- pretty decent at that time. However, with short-term rates elevated, that borrower is now facing an adjustment to 7% -- and absent any rate cap on the first adjustment, even higher. These borrowers can refinance to a new more- fixed product with a rate of perhaps about 6%. If that step-up in rate is onerous, interest-only payments will provide some relief.

A borrower with a hybrid 5/1 ARM written in late 2001/early 2002 faces the same quandary, but they have already been paying a rate in the low sixes, so they can sidestep any increase in rate and payment with a refinance to a new fixed rate mortgage at about the same rate.

We've discussed two classes of potential refinancers so far: those with a payment-option ARM or Hybrid ARMs. But refinance activity in recent months has featured a fair level of borrowers pulling cash out of their properties. "Cash-out refinances" are best used in conjunction with an opportunity to lower the overall interest rate of the mortgage, but there are plenty of borrowers today with existing loans with rates in the low to mid-sixes who can pull cash out with no uncomfortable rise in monthly payment. A two-year old $100,000 loan at 6% carries a fully-amortizing payment of $600 per month, and a $25,000 cash-out added on after two years means an increase in payment of just $132 per month.

Given the massive amount of paperwork involved with a refinance, why not simply set up a Home Equity Line of Credit (HELOC) or get a Home Equity Loan? You could, but rates for those products are over (perhaps well over) 8% for most borrowers, and the shorter terms available mean higher monthly payments for the same amount of cash,plus two mortgages for the borrower to manage. A $25,000 10-year Home Equity Loan at an average 8.21% carries a monthly payment of $306 -- and you still have to make the $600 per month payment for the first mortgage, as well.

We've looked at several types of potential refinancers so far. The last category includes those who took 'piggyback' mortgages over the past few years. In a piggyback arrangement, two mortgages are written simultaneously: a first mortgage is written for 80% of the loan amount, and the second mortgage takes the place of a portion (or all) of the down payment. These are also called "80-10-10", "80-15-5", or even "80-20" products, depending upon how the loans are structured.

The first mortgage portion is a competitive market rate, because it can be sold into the secondary market easily. The second mortgage portion can typically also be sold, but the smaller loan amounts mean smaller profits to the lender, and as a second lien, a greater risk of default. As a result, the second mortgage portion of a piggyback can feature fixed rates of 8% to 9% or more. Piggybacks written with a variable-rate Home Equity Line of Credit as the second portion may be priced at Prime + 2% to 4%, yielding interest rates for that portion from 10.25% to 12.25%. Plus, there's the added hassle of two sets of loan paperwork.

To put this into perspective, the combined payments for a 6% 30-year first mortgage of $80,000 coupled with a 20-year, $20,000 second mortgage at 8% are $647 per month.

Provided the borrower's property has appreciated over the past couple of years -- and for most markets that's likely, even given the present softness in prices -- a borrower may be able to consolidate a piggyback mortgage into a single loan. This means only one monthly payment, one set of mortgage documents, and potential for savings. A borrower whose $100,000 property was financed with an 80%/20% piggyback two years ago would need to have seen a 12% rise in price in 2005 followed by an 8% rise in 2006 in order to be very close to an 80% LTV new mortgage which doesn't requite either a piggyback or PMI. Also, borrowers who are close to that 80% LTV level may also find it more beneficial to accept an MI policy, as the level of needed coverage could make it fairly inexpensive.

Without MI, a new $97,094 (remaining balances of the two loans after two years) loan for 30 years at 6% carry a combined monthly cost of $582. The borrower has consolidated in one loan, and is "saving" $65 per month.

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